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By Adam McCullough, CFA | 10-25-2017 11:00 AM

Do Your Economic Interests Match Your Passive Partner's?

Morningstar research finds that fund sponsors that align their economic interest with the fundholders' have offered better results.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Morningstar's analysts believe that investors in passive funds should partner with firms that align their economic interests with their own. Joining me to share some research on this topic is Adam McCullough. He is a passive strategies analyst in Morningstar's research team.

Adam, thank you so much for being here.

Adam McCullough: Thanks for having me, Christine.

Benz: You and the team came out with a research paper where you looked at how firms stack up in terms of stewardship of their passively managed assets. Let's talk about the goal of the research. What are you trying to shine the light on?

McCullough: Our goal was to look at the largest passively managed fund sponsors in the U.S. and look at which of those fund sponsors do a better job of aligning their economic interest with their fundholders. In the past, we have seen that fund sponsors that do align their economic interest with the fundholders have offered better long-term category-relative performance compared to those that don't.

Benz: The overarching theme is, alignment of economic interests. Why do you think this is important?

McCullough: You want to look for firms that have your best interest at heart. To do this, what we did was we looked at four different categories. The first one was fund fees; how are these sponsors' funds price compared to other category relative offerings? Obviously, you want cheaper funds because then you keep more of the return as an investor.

The second big one was securities lending revenue splits. This is more of a passive fund-focused area. This is looking at of all of the assets that the fund holds, it can lend out securities to broker/dealers or hedge funds and earn an income on that. But the split between what the fund company keeps and what it passes along to the fund is not consistent. We want to look at what the different practices there, which fund sponsors pass more back to the fund, pass less back to the fund.

The third big area was product development. We are looking for fund companies that launch products with the long-term investor in mind that have a strong investment merit and aren't just going to throw a bunch of products out there, see which ones gain assets, keep those, and then close the ones that lose assets or just don't have a strong base to begin with. We think there, that just shows that the fund company is looking for funds that offer long-term investment-focused strategies as opposed to, this is a hot trend that we are seeing in the market; let's launch a fund and see if it gets assets; if so, great; if not, we'll close it and move on to the next thing. It really shows a thoughtfulness and that they have your interest in mind over the long haul.

The fourth big thing was looking at the investment and the portfolio management team and the trading infrastructure. From the passive side, you aren't looking for star PMs or analysts to call, this is the next hot stock. You're looking for an exposure to an asset class, so how well do they track the index that the funds are trying to track.

Benz: Let's take these metrics and home in on a couple of them. Let's start with fees. I know for a lot of passive fund investors their research might begin and end with an assessment of fees. But let's take a look at how the various firms stack up on that metric.

McCullough: The fees are obviously very important. There's many ways to look at it. I think an important metric that we include in the study is looking at the category relative fee ratio. What that does is, it takes all of the sponsors' offerings and divides that sponsor's fund fee divided by the Morningstar category average for only passives. So, for instance, if Vanguard has a large-cap blend fund with the 10-basis-point fee, the average passive fund in the category is 50 basis points, it would earn a 0.2. It's 20% of the category. That helps take into account product lineup differences and also looks at it more on an apples-to-apples basis.

Benz: When you stack the firms up, the various passive fund firms--it's pretty concentrated among a handful of providers--but let's talk about who looks best from that standpoint.

McCullough: On the fee standpoint, you see on a category-relative basis, on the passives only, you see Vanguard, Fidelity, and Schwab do a very good job. That's really just showing their commitment to offering core, building-block portfolios that are cheap relative to their peers.

Benz: I want to talk a little bit more about this securities lending piece. You talked about what it is in general. Let's talk about how the firms that you assessed stack up on this measure.

McCullough: Fees are easy. They are intuitive, it's straightforward: This is what I'm being charged every year. Securities lending is a little bit different. I think it's getting a little bit more interest now because of the assets these passive funds have gathered. On the securities lending side, what these fund companies do is they say, of the assets, if we have an S&P 500 tracking fund, we own all the stocks in S&P 500. The other players out there, hedge funds, broker/dealers who want to borrow those to either sell short or to hedge certain exposures that they have. These fund companies will lend out those securities to those third parties and earn short-term rebate on those. The biggest thing you want to see there is how much of that income being generated by securities lending is being passed back to the fund. 

Benz: To fund shareholders.

McCullough: To fund shareholders. It's shown in the fund's annual report as an income from securities lending revenue. But that's a net figure. You don't know what they are actually paying the securities lending agent, whether that's their own agent or a third party to lend those securities. What we want to do is just see what the differences were. What we did was that of those largest U.S. fund companies that reported, BlackRock was taking the largest percentage of securities lending revenue from the funds at about 30% and Schwab …

Benz: So, this is a moneymaker for them?

McCullough: This is a moneymaker. They have an affiliated internal entity called BlackRock Trust Company, that actually runs the securities lending program. Investors are indemnified from any losses, so if they incur a loss, if someone defaults and doesn't his security, BlackRock makes the fund investor hold, but they also take 30% of the securities lending revenue on average from that fund.

Then on the other end of the spectrum, you see a company like Schwab has as low as 7% to 10% as being sent along to their third-party securities lending agent. But the difference there is that BlackRock is paying another entity within the BlackRock umbrella, whereas Schwab is using a third-party entity because they don't either have the expertise in house or aren't willing to do that from securities lending perspective.

Benz: Does that mean that the Schwab index fund shareholders or ETF shareholders though are getting a bigger share of the securities lending proceeds?

McCullough: They are getting a bigger share. The question becomes, how big is the pie? That's probably future research that we are going to look into is, if fund companies say that they can generate more revenue with the same basket of securities, and they are taking a larger chunk of a larger pie, maybe that's worth doing. But ultimately, we know--this is like fees--we know that what's taken is fixed every year, or changing a little bit. But if you have more of that upfront, it's going to be better regardless of how big the pie is.

Benz: Let's take a look at product development. I guess, at first blush, if you are mainly someone who is going to invest in a core-type product, you might say, well, what do I care if they are launching a bitcoin ETF or some other type of gimmick. Why do you think investors should pay attention to this?

McCullough: This is more from a fund company behavior perspective lens to look at them through. If these are fund companies that are offering a ton of products that are launching them frequently and closing them frequently, they might not have your best interest at heart. They may not say, oh, we only want to bring to market funds that we think have a long-term investment merit. They've thoughtfully looked at the lineup and said, these will be around for the long run, they aren't launching gimmicky type of products. There is not necessarily a direct correlation here, but there's kind of an indirect view as to how they view fundholders. Are these partners for them, long-term investors, are these a way to gain assets for their company?

Benz: When you stack up the various passive fund shops on this basis, who looks best and who looks not so great?

McCullough: It's not surprising that the companies that you think would do well, do do well. Vanguard, looks good here. More recently, Schwab also looks good. They did a fund lineup overhaul in 2009. Before that, they had a lot of funds that they closed. Now, in the past five years or so, it's been a lot more stable. DFA has only closed four funds in the past 10 years. Vanguard hasn't closed a fund or an ETF since they launched their first one in May 2001.

That just shows that this fund is going to be around for the long haul, and you know that if you are there, you are not going to have to worry about a fund closure or having to find a new way to get that exposure if the fund does close.

Benz: Your overall message is, choose your partners carefully when you're investing in passive products.

McCullough: Yes, exactly.

Benz: OK, Adam. Thank you so much for being here to share this research with us.

McCullough: Thanks for having me.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.

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